Checking Up on the Buy-High, Sell-Low Crowd

June 3, 2008

Fund investors have a bad habit of buying high and selling low. They do so with specific funds, categories of funds, and the stock market in general. This behavior is one of the top reasons why, as studies have shown, fund investors underperform the stock market. This behavior is also the basis of most of our contrarian fund-investing decisions – we try to invest the way the typical fund investor does not.

When the market gets more volatile – particularly when it is going down – investors tend to get more irrational and try to “do something” proactively to avoid more losses or make more gains.

You’d expect investors to want to buy more as prices fall and cut back after big moves up – but in practice they tend to sell after a fall thinking more losses are coming, then buy back in after the market turns positive, fearing missed gains almost as much as more losses.

This behavior is generally reinforced by the financial media. CNBC tends to just seem more optimistic – both the hosts and the guests – after the market is up, and more dire after big drops. Newspapers tend to harp on the bad after the fall, and extol the virtues of the most recent 100 point gain. This whole system is practically designed for performance chasing.

So what has been going on lately? Here is a table of the net flows, in billions of dollars, into stock funds each month over the last year, and the resulting next month’s return for the S&P 500:

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<th width="74" scope="col"><div align="center">Month</div></th>

<th width="84" scope="col"><div align="center">Flow In Billions</div></th>

<th width="69" scope="col"><div align="center">S&P Next Month</div></th>

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For example, investors put 9.59 billion dollars into stock funds in February 2007, and the S&P 500 (with dividends but excluding fees to own an index fund) returned -0.43% in March of 2007.

If you bought the S&P 500 at the end of a month that fund investors took money out of stock funds, and sold at the end of the next month (unless fund investors took money out again in which case you would remain invested), you would have been in the market for four months over the last twelve, with a total return of 4.53%.

If you only owned the S&P 500 in months following months that other fund investors added money to stock funds, you would have been in the market eight months, with a total return of -10.7%. That’s a pretty big difference in just a year.

Of course, this was just a one-year period, and one in which the market has been mostly down. Yet, when fund investors sold, the market generally did well relative to the months fund investors added money. We’ve seen this pattern before, most markedly in 2002 when fund investors bailed out of stock funds at the very bottom of the 2000-2002 bear market.

This graphic shows the S&P 500 (blue line) and the Dow (red line) over the last few months with net flows in or out of stock funds in billions during the month period in the color band above it in the graph. You can see the pattern of selling after trouble, and buying when things seem to be turning around.

We do feel we missed an opportunity to increase our stock allocation after fund investors panic sold in January – though these moves were happening so fast that by the time we knew how much was going out of funds the market had rebounded.

We intend to increase our stakes slightly after the next period of big net sales by fund investors. We may get this opportunity soon as the recent drop in the stock market should shake out some more fund investors who just bought in during April.

Checking Up on the Buy-High, Sell-Low Crowd

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